Regulations finalize FEEP method to determine 987 gains and losses

The IRS and the Treasury Department published final regulations related to Internal Revenue Code (IRC) Section 987 “Branch Transactions” and the determination of taxable income or loss and foreign currency gain or loss with respect to a qualified business unit (QBU). A Section 987 QBU constitutes the activities of a trade or business that maintains separate books and records in a functional currency different from its owner. The final regulations are generally effective for tax years beginning after Dec. 31, 2024, but apply retroactively to QBUs that terminated after Nov. 9, 2023.

The FEEP method for calculating gain, loss, and recognition under Section 987

The final regulations adhere to the foreign exchange exposure pool (FEEP) method that was introduced in the 2016 proposed regulations. The method requires taxpayers to perform several computations on an annual basis, including:

• Section 987 taxable income. 
• Net unrecognized Section 987 gain or loss. 
• Section 987 gain or loss recognized.

Further, pursuant to the transition rules, taxpayers who had not adopted these rules previously are required to compute pre-transition gain or loss under their previous Section 987 methodology on the day before the transition date. These computations are described in more detail below.

Section 987 taxable income is determined annually in the QBU’s functional currency and translated at the yearly average exchange rate for the taxable year, with certain exceptions. If the QBU’s operations generate items of income, gain, deduction, and loss that are denominated in any nonfunctional currencies, those amounts are generally translated into the QBU’s functional currency at the spot rate on the date the item is taken into account. For fixed assets where there is recovery of basis through depreciation, amortization, depletion, or disposal, the deductions representing recovery of basis should be translated using an average rate from the year of acquisition. Additionally, cost of goods sold can be translated using either a simplified method, which translates at an average rate with certain adjustments, or taxpayers can elect to translate using historic rates when inventoriable costs were capitalized.

Net unrecognized Section 987 gain or loss of a QBU is determined on an annual basis in the owner’s functional currency. It’s the sum of the QBU’s net accumulated unrecognized Section 987 gain or loss for all prior taxable years and the unrecognized Section 987 gain or loss for the current taxable year. Unless a current rate election or annual recognition election (discussed below) is in place, taxpayers calculate unrecognized Section 987 gain or loss for a taxable year using the following 10-step process:

• Step 1 requires the determination of the change in owner functional currency net value (OFCNV), which equals OFCNV on the last day of the tax year less OFCNV on the last day of the preceding tax year. OFCNV looks at the net assets of the tax basis balance sheet of the QBU, with marked items translated into the owner’s functional currency at the end-of-year spot rate and historic items translated into the owner’s functional currency at the historic rate. The current rate election allows for the calculation of OFCNV to be done based on certain elements of the old earnings and capital method in lieu of using a tax basis balance sheet.
• Steps 2–10 involve adjusting the amount in step 1 for a variety of items, such as:
  • Step 2-5, transfers between the QBU and its owner.
  • Step 6, Section 987 taxable income.
  • Steps 7 & 8, nondeductible and nonincludable items.
  • Step 9, off balance sheet items of income.
  • Step 10, residual amounts.

Taxpayers that have made a current rate election or annual recognition election would only follow the process from steps 1–5 and 10.

The owner’s Section 987 gain or loss recognized annually equals the product of the net unrecognized Section 987 gain or loss and the owner’s remittance proportion. The owner’s remittance proportion equals the amount of any remittance divided by the sum of the QBU’s gross assets basis and the amount of remittance. A remittance is determined in the QBU’s functional currency and equals the excess of the amounts transferred from the QBU to the owner over the amounts transferred from the owner to the QBU during the taxable year. Transferred marked items are translated into the owner’s functional currency at the spot rate applicable to the date of transfer while transferred historic items are translated into the owner’s functional currency at the historic rate.

Section 987 elections for alternatives to the FEEP method

The final regulations make available certain elections that provide for alternative approaches to the FEEP method, including the current rate election, the annual recognition election, and the Section 988 mark-to-market election (collectively, Section 987 elections). A Section 987 election applies to every QBU owned by the owner, applies to all members of a consolidated group, and remains in effect until revoked. In the first year the regulations are effective, or the first year that a taxpayer owns a QBU, the election can be made with the owner’s timely filed tax return. If an election isn’t made in the first year, the election must be made by filing a statement with the IRS on or before the first day of the taxable year to which the election applies. Once made, the elections may not be revoked without consent for 60 months. Once revoked, new elections may not be made without consent for 60 months. 

The current rate election allows a taxpayer to treat all assets and liabilities attributable to a QBU as marked items, subject to loss suspension rules. The election allows taxpayers to translate all income statement items using the average rate rather than needing to go item by item and translate accordingly. With this election in effect, Section 987 losses are only deductible to the extent of Section 987 gains within the same recognition grouping in the current and prior three years.

The annual recognition election requires a taxpayer to recognize Section 987 gain or loss on an annual basis. When the current rate election and the annual recognition election are made in conjunction, the loss suspension rules don’t apply.

The Section 988 mark-to-market election allows the taxpayer to realize built-in gains or losses annually with respect to Section 988 transactions of the QBU, generally understood to be nonfunctional currency transactions that give rise to functional currency gains and losses.

Further to the above, an election to treat all QBUs with the same functional currency as a single QBU was maintained in line with previous versions of the regulations.

Transition rules depend on pre-transition methods

The approach to calculating pre-transition gain or loss is based on whether the taxpayer applied an eligible or ineligible pre-transition method. If an eligible pre-transition method was used, the amount of pre-transition gain or loss is determined in reference to the Section 987 gain or loss that would have been recognized under the method if the QBU terminated and transferred all of its assets and liabilities to its owner, subject to certain adjustments. If an ineligible method was used, the taxpayer must retroactively compute annual unrecognized Section 987 gain or loss for all tax years beginning after Sept. 7, 2006, through the transition date, reduced by Section 987 gain or loss previously recognized.

Pre-transition gain is treated as net accumulated unrecognized Section 987 gain. Pre-transition loss is generally treated as suspended loss. If a current rate election is in effect (and an annual recognition election isn’t in effect), the pre-transition loss is treated as net accumulated unrecognized Section 987 loss. Taxpayers may elect to recognize pre-transition gain or loss ratably over 10 years.

Suspended loss rules for certain 987 losses

For a taxable year in which a current rate election is in effect, but an annual recognition election is not, the net unrecognized Section 987 loss that would otherwise be recognized instead becomes a suspended Section 987 loss. A de minimis exception applies to losses that don’t exceed the lesser of $3 million or 2% of the total gross income of the owner and all members of the owner’s controlled group.

Pursuant to the loss-to-the-extent-of-gain rule, the amount of suspended Section 987 loss recognized is determined separately by recognition-grouping and is limited to the sum of the current year gain and the lookback gain amount from the three preceding taxable years in the recognition group.

Taxpayer considerations

Compliance with these final rules can still be a significant burden on taxpayers even with the various elections designed to simplify the implementation of the new regulations. Taxpayers should evaluate whether they have identified all applicable QBUs in their organizational structure and whether they have been historically tracking Section 987 appropriately to determine the approach to transition. 

For those that have delayed tracking Section 987 or have used an improper method, the regulations provide guidance to come into compliance and may require significant historic data as far back as 18 years. For those needing significant historical data, taxpayers should review their available records and work with their advisors to get the appropriate information to complete the transition to the new regulations.

For taxpayers who have had a QBU terminate on or after Nov. 9, 2023, and have already filed a tax return, consideration should be given to amending the tax return. Additionally, taxpayers should also be aware that the final Section 987 regulations also apply where a QBU terminates as a result of an entity classification change that’s filed on or after Nov. 9, 2023, even if the election is effective prior to Nov. 9, 2023. Lastly, for those taxpayers with QBU’s that terminated for a tax year that hasn’t yet had a return filed, they’ll need to adopt the new regulations on this tax return.

To learn more about how these final regulations affect your business’s overseas operations, please consult with your tax advisor.